It's tax time again! As you file your return this year, pay attention to your effective tax rate. This number will help you to understand your individual tax situation and make informed decisions that may lessen your tax burden.
First, you should understand the difference between your marginal tax rate and your effective tax rate. Your marginal tax rate is the rate at which your last dollar of taxable income is taxed. Taxes are calculated on a sliding scale. The more you earn, the higher your tax rate. No matter your taxable income, the first dollars of taxable income are taxed at low rates. The tax rate increases as you reach certain thresholds of taxable income but only the amount above the threshold is taxed at the higher rate.
Not all of your income is taxed at the highest rate. Your effective tax rate takes into account all of your taxes and credits, and exposes the average rate of taxation for all of your dollars. If you prepare your own taxes using commercial software, the effective tax rate is probably calculated for you. If you need to calculate it yourself, you would do so by dividing your total tax obligation by your total taxable income. The resulting effective tax rate is very likely to be higher or lower than your marginal tax rate.
So, now that we know the number, how do we use it? Your effective tax rate is an important factor in making a number of financial decisions. Among these is the decision about how best to save for retirement. Many employers offer tax deferred retirement plans such as 401(k)s or 403(b)s. These plans allow employees to defer taxation on income that is contributed directly to the retirement plan. That means that you won't pay taxes on that income now but, you will pay taxes when the funds are distributed or withdrawn.
If your effective tax rate is low, it may not be in your best interest to defer payment of taxes to a later date. Tax rates are at historically low levels and if your tax rate is also low, it may be best to pay off the IRS now. Check with your employer to see if a Roth 401(k) or Roth 403(b) plan is available. If so, take advantage! A Roth 401(k) or Roth 403(b) will require after-tax contributions (remember, we're paying off the IRS at a low rate now) but all of the earnings will grow tax free. Yes, tax free, if held for more than 5 years and when withdrawn during retirement.
If a Roth retirement plan option is not available through your current employer, a good financial planning strategy is to contribute only enough to your company retirement plan to receive any match for which you are eligible and then contribute the remainder to a Roth IRA. The maximum contribution for 2009 is $5,000 if you are under age 50 and $6,000 if you are age 50 or older.